Crowdfunding - The next big thing?

It is well documented that small, start-up firms face difficulties when it comes to securing external finance, especially following the economic crisis. To address this problem, and in a bid to help close the ‘finance gap’, various crowdfunding platforms have been developed; a new source of finance for start-up firms. With popularity of crowdfunding growing, it is interesting to see how this process works and whether it is successful for both companies and investors.

Crowdfunding helps firms secure funding from large audiences, providing investors with the opportunity to invest very small amounts through online platforms. The minimum investment is usually as little as £10. This blog will focus on equity crowdfunding in which people invest in an unlisted company in exchange for shares. As a shareholder, the investor will benefit if the company is successful; however, they may also lose their investment if it is unsuccessful. Around £84m was raised from equity crowdfunding in 2014, triple the amount from 2013. According to several reports, the platform grew by 410% from 2012-2014, demonstrating its surge in popularity.

An increasing number of companies are using crowdfunding as well as other forms of finance such as venture capital. This is the case for JustPark, who run a mobile app which connects owners of parking spaces with drivers looking for somewhere convenient to park. JustPark is also funded by the international venture capital firm Index Ventures and BMW’s technology incubator. JustPark invited its users to become shareholders in a £1m crowdfunding campaign. The company announced it would use this money to develop new technology and to build its community of users. The minimum investment was set at £10, encouraging even small investors to invest.

Kozinets (1999) developed four member types in an online community; Tourists, Minglers, Devotees and Insiders. The study suggested strategies should be focused on devotees, who have a strong interest and enthusiasm but not many social attachments, and insiders who have both strong social and personal ties. JustPark seemed to adopt this strategy, providing an exclusive offer to users of the app 48 hours prior to the debut. This encouraged those considered ‘insiders’ to invest in the company. JustPark offered up to 4.76% equity, giving the business a valuation of just over £21m.

This strategy proved successful for JustPark, who raised almost half of their £1m target after only 12 hours of its debut on the crowdfunding platform Crowdcube. The campaign is now closed, with JustPark raising £3.7m, marking the world’s most successful equity crowdfunding campaign. The company also benefited from the increased exposure; experiencing a surge in job applications and a 300% increase in downloads of the app. This provided relatively easy access to finance for JustPark, allowing the company to grow and develop its operations.

However, despite the benefits to businesses, there is some concern regarding the risks associated, especially as it is a relatively new phenomenon. The Financial Conduct Authority, the UK regulator, warns that most start-ups fail and investors are likely to lose their money. It also raised concerns over how clearly investors are being told the terms of their investment. Many are exposed to the risk of dilution when more shares are issued. The FCA has made an attempt to oversee the sector, introducing rules limiting the amount that can be invested. However, in reality these rules can easily be avoided as they rely on self-certification.

So, in light of the associated risks, is crowdfunding an innovative platform that will allow businesses to set up and expand, or merely a current trend that will phase out once investors start losing money? The answer is somewhat difficult to comprehend due to how new crowdfunding still is. To companies, at least, it provides access to funding that might otherwise have not been available and provides an alternative to loans. They can also benefit from powerful word-of-mouth marketing and relatively quick access for funds. For them, I believe an obvious answer would be that yes, crowdfunding benefits them.

However, it is much more complex from the perspective of investors. Whilst they have the opportunity to invest small amounts in companies that interest them, returns are not guaranteed and the relatively unregulated nature of crowdfunding remains a concern. Some cases look to be a success, such as the JustPark app which received a surge in downloads following the increased exposure. However, this does not guarantee the company can maintain this in the long term, which could potentially result in the destruction of shareholder wealth. I propose that crowdfunding will appeal to those willing to take a risk and, to an extent, gamble on their investments. This relates to the indifference curve which represents individual preferences and risk profiles. Those who are willing to take a risk may hold a portfolio that has higher associated risk, in turn expecting higher returns. What is apparent is that, should the sector really take off, more regulation is required to encourage stability.

References

Belleflamme, P., Lambert, T. & Schwienbacher, A. (2014). Crowdfunding: Tapping the right crowd, Journal of Business Venturing, 29(5), 585-609. doi:  10.1016/j.jbusvent.2013.07.003

Curtis, S. (2015). JustPark invites users to become shareholders in £1m crowdfunding campaign. Retrieved 25^th April 2015, from http://www.telegraph.co.uk/technology/news/11408609/JustPark-invites-users-to-become-shareholders-in-1m-crowdfunding-campaign.html

Evans, J. (2014). Equity crowdfunding thrive despite high risks. Retrieved 25^th April 2015, from http://www.ft.com/cms/s/0/3ba47796-7624-11e4-9761-00144feabdc0.html#axzz3YEO9E1Tx

Evans, J. (2015). Start-ups pile into crowdfunding platforms. Retrieved 24 April 2015, from http://www.ft.com/cms/s/0/c3d01f9a-b75a-11e4-8807-00144feab7de.html#axzz3YEO9E1Tx

Fleming, S. (2015). Watchdogs home in on financial technology. Retrieved 24^th April 2015, from http://www.ft.com/cms/s/0/97b31b68-9da3-11e4-8ea3-00144feabdc0.html#axzz3YEO9E1Tx

Francis, J. & Kim, D. (2013). Modern Portfolio Theory, Hoboken: John Wiley.

Gerber, E. & Hui, J. (2013). Crowdfunding: Motivations and deterrents for participation, ACM Transactions on Computer-Human Interaction, 20(6). doi: 10.1145/2530540

Just Park. (2015). Crowdfunding campaign. Retrieved 25^th April 2015, from https://www.justpark.com/invest?source=awin&utm_source=Affiliate_Window&utm_medium=78888&utm_campaign=Affiliate_Window_Sale&awc=6188_1429958842_89a4a124a8f118e4de88be894d4e360b

Kozinets, R. (1999). E-tribalized marketing? the strategic implications of virtual communities of consumption, European Management Journal, 17(3), 252-264. doi:10.1016/S0263-2373(99)00004-3

Winterbottom, A. (2015). BMW-backed car parking app raises half crowdfunding target on debut. Retrieved 25^th April 2015, from  http://www.reuters.com/article/2015/02/13/us-fundraising-uk-justpark-idUSKBN0LH1XJ20150213

Has Royal Dutch Shell paid too much for BG?

One of the key aspects of mergers and acquisitions is the valuation of the target firm. How do bidding companies calculate its worth and, more importantly, how do they know they have secured a good deal? A good deal should technically prioritise shareholder wealth maximisation, whilst a bad deal could destroy it. The same could be said for the target company; how do they evaluate offers for the company and ensure they obtain the highest price possible? Due to the differing needs of both a target and bidding firms, a ‘halfway’ figure must be determined; one that is attractive to both the target and bidding firm.

The oil industry is going through a difficult time with oil prices reaching a 6 month low, discussed in a previous blog. Royal Dutch Shell (Shell) has just announced the takeover of BG in a £47bn deal, making it an incredibly large acquisition. However, the market forecasts dramatic cuts in the profits of Shell, so how do they know they can afford the merger? It seems like a very large price to pay for such a clear gamble relying on the recovery of the oil industry. Shell’s share price was down 8% upon the announcement, leading some analysts to claim Shell have paid too much for BG (figure 1). One potential suggestion is that Shell managers are infected with hubris, resulting in them overpaying for BG as they are overconfident in their ability to run it. Paying too much for a target is an easy way to destroy shareholder wealth. It is interesting to consider the method adopted by Shell to come to the valuation of BG.

Figure 1: Royal Dutch Shell Share Price
Data from London Stock Exchange (2015)

One possible method is stock market valuation, which relies on the efficient market hypothesis. Using this method of valuation, the value is simply the multiplication of the number of shares by the current market value. However, the market is not perfectly efficient in reality implying this is a flawed technique. At best, it may have provided Shell with a minimum value of BG. Shareholders usually require a substantial premium on top of this to be attracted to an offer. In most cases this is around 30%. In the Shell-BG merger, this premium was 50% on BG’s share price on 7^th April. This may provide further evidence Shell overpaid for BG.

A more complex method comes in the form of an asset-based valuation, which values a company by deducting assets from liabilities. This can be achieved most easily by using the book value, simply by taking the amount recorded on the financial statements. Whilst this is easy to do, it will not always result in an up to date value of the asset; potentially not the best guide to an assets current worth. Instead, Shell could have used the net realisable value of the assets, also known as the amount the asset could currently be sold at in the market. Although, this can present problems if an asset is unique to the company, as it would not have a market value. This may have caused problems for Shell regarding the intangible assets of BG which substantially increase the value of the company. For example, BG has a large number of oil and gas reserves, which may be difficult to value if they are unexplored. The exploration activity would also be difficult to value. This suggests asset-based valuation may not have been the most appropriate for Shell to use.

Income-based valuation provides an alternative viewpoint and measures value based on hypothetical forecasts. One of the way of achieving this is through the P/E ratio, which is simply the share price divided by the latest earnings per share. This provides an indication of the return on equity shareholders will receive in the future. Despite being widely used, it is a very basic method making it quite limited. It provides a snapshot of one period, assuming this will remain constant but this is unlikely to be the case. The selection of a benchmark P/E ratio can also be problematic. As Shell and BG are in the same industry this method may have been used, with the industry average set as a benchmark. The P/E model has wide practical application which may have encouraged its use.

Discounted cash flow is an alternative forward looking method. This discounts the future free cash flow of the companies, and allows for future changes. However, it is difficult to account for expected synergies which may affect the valuation as the Shell-BG merger is expected to created around $1bn of synergies. Its main benefit is that it acknowledges the time value of money; however, it may be difficult to decide upon a time period and appropriate terminal value.

Ultimately, it cannot accurately be predicted how Shell came to the valuation of BG. What can be suggested is that I believe Shell will have used a wide range of methods before combining these to establish the most appropriate value. Each method has its drawbacks, and they could result in ambiguous results which makes this the most suitable response. The key thing that Shell should have kept in mind is whether the value was going to create shareholder value. As for the critics who are claiming Shell paid too much for BG; time will tell as the merger unfolds and it can be assessed whether Shell manage to pull of this ‘mega-merger’. In my opinion it is definitely a big risk for Shell to take, as its success depends on the full recovery of the oil industry which cannot be guaranteed. The premium of 50% on top of BG's market value also seems an abnormally high figure, suggesting the managers could potentially have been affected by hubris. If it turns out Shell have overpaid for BG, it will be shareholders that bare the brunt of that and ultimately lose wealth.

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson Education.

BBC News. (2015). Royal Dutch Shell to buy BG Group in £47bn deal. Retrieved 15^th April 2015, from http://www.bbc.co.uk/news/business-32213341

Chazan, G., Barrett, C. & Oakley, D. (2015). Shell’s £47bn swoop on BG Group opens way to wave of energy deals. Retrieved 15^th April 2015, from http://www.ft.com/cms/s/2/140c4f2e-ddb7-11e4-8d14-00144feab7de.html#axzz3ZTGP71bw

Ficenec, J. (2015). Questor share tip: Are Shell shares a buy after BG deal? Retrieved 15th April 2015, from http://www.telegraph.co.uk/finance/markets/questor/11523486/Questor-share-tip-Stay-invested-in-Shell.html

Kavanagh, M. (2015). Five questions for Shell over BG Group deal. Retrieved 15^th April 2015, from http://www.ft.com/cms/s/0/8e708780-ddc1-11e4-8d14-00144feab7de.html#axzz3ZTGP71bw

London Stock Exchange. (2015). Royal Dutch Shell Share Price. Retrieved 8th May 2015, from http://www.londonstockexchange.com/exchange/prices-and-markets/stocks/summary/company-summary-chart.html?fourWayKey=GB00B03MM408GBGBXSET0

Roll, R. (1986). The Hubris Hypothesis of Corporate Takeovers, The Journal of Business, 59(2), 197-216. Retrieved from JSTOR http://www.jstor.org/

Ryan, B. (2007). Corporate Finance and Valuation, London: Thomson Learning.

Sudarsanam, S. (2010). Creating Value from Mergers and Acquisitions, (2^nd ed.), Harlow: Pearson Education.

Watson, D. & Head, A. (2013). Corporate Finance: principles and practices. (6^th ed.), Harlow: Pearson Education.